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You don't find quality companies with increasing dividends and a low payout ratio in the undervalued territory very often. To find such companies, our screen comes up with a list of 27 companies using the criteria such as the following:

  1. The current dividend yield for each of these companies exceeds its average dividend yield in the last 7 years,
  2. Each company has increased its dividend in each of the last 7 years,
  3. The dividend growth rate for each of these companies during the last 7 years is at least 3%,
  4. The payout ratio for each of these companies during the last 12 months is under 50%,
  5. The liabilities to asset ratio for each of these companies is less than its industry average,
  6. The diluted EPS for each of these companies exceeds its industry average during the last 3 years,
  7. None of these companies is from the Utilities sector,

To further improve the quality of the companies in our list, we added the following two additional criteria:

  1. The companies should have been growing their free cash flow faster than their sales during the last 5 years and
  2. The companies should have been growing their free cash flow faster than their net income during the last 5 years.

We now have a list of 18 companies. These are the companies which pass some stringent quality criteria regarding the dividends, income, balance sheet and the free cash flow. But we do not stop here…

We further shortlist the companies into the following three, based upon their compelling historical and relative valuations: Northrop Grumman Corporation (NYSE:NOC), Walgreen Co. (NYSE:WAG) and Medtronic, Inc. (NYSE:MDT).

You see, each of these companies is trading not only near or below its 7-year average earnings, book, sales and free cash flow multiples, each is are also trading at a discount to the broad market.

Northrop Grumman Corporation: Northrop Grumman provides products, services, and integrated solutions in aerospace, electronics, information and services to its global customers. The company conducts most of its business with the United States government, principally the Department of Defense and intelligence community. It also conducts business with local, state, and foreign governments and domestic and international commercial customers.

The declining defense and intelligence expenditure in the USA and across the world has translated into the declining sales for Northrop Grumman during the last three years. The big news of interest is President Obama's re-election. If things go the way they have during the first term of President Obama, expect continuing pressure on the defense companies for another term. Having said that, in our view, Northrop's dividend does not look threatened and due to Northrop's cheap valuation currently, there might be some capital gain on the cards.

Walgreen Co.: Walgreen, based in Deerfield, Ill., is the nation's largest pharmacy chain, with more than 8,200 outlets in the United States operating under the Walgreen and Duane Reade names. The company provides its customers with access to consumer goods and services, pharmacy, and health and wellness services. The company offers its products and services through drugstores, as well as through mails, by telephone and online. The company sells prescription and non-prescription drugs, as well as general merchandise.

Walgreen and Express Scripts (NASDAQ:ESRX) locked horns in 2011 over a payment dispute which cost Walgreen more than $4 billion in the annual revenue, according to the estimates. In FY 2011, Walgreen filled more than 800 million prescriptions via its stores and more than 80 million prescriptions managed by Express Scripts. Now that Walgreen has reached an agreement with Express Scripts, it will have to fight hard to win back the clients Walgreen lost to its rival CVS Caremark (NYSE:CVS) due to this dispute. Walgreen may have to invest in the promotional activities to recover that $4 billion in lost revenue.

Another thing to keep in mind is that a lot of brick and mortar stores have been Amazoned (NASDAQ:AMZN) in the last few years. Walgreen having a significant list of its SKUs overlapping with Amazon, may lose a fair share of its business to Amazon. The good news however is that due to the urgent-requirement nature of some of Walgreen's products, this part of Walgreen's business is not expected to be pressured by Amazon in the foreseeable future.

Medtronic, Inc.: Medtronic is engaged in the medical technology - alleviating pain, restoring health, and extending life for people with chronic conditions worldwide. Medtronic develops and manufactures a range of products and therapies providing a continuum of care to diagnose, prevent and monitor chronic conditions. With more than 45,000 employees and a market capitalization of over $40 billion, Medtronic is the world's largest independent medical technology company. Approximately 45% percent of company revenue comes from outside of the United States, and this percentage is growing. Medtronic's product revenue break up is the following: Cardiac Rhythm Disease Management 31%, Cardiovascular 21%, Spinal 20%, Neuromodulation 11%, Diabetes 8% and Surgical Technologies 8%.

According to a Medtronic's presentation at the UBS Global Life Sciences conference in September, Medtronic expects its free cash flow over the next five years to be $25 billion (about 60% of the current market cap). Over half of this free cash flow (i.e. about 30% of the current market cap) is expected to be returned to shareholders directly as dividends and indirectly as the stock repurchases. Valuation wise; even though Medtronic is trading more toward the high end of its 52-week range, it's still trading at a discount to its 5-7 year multiples. We think it's attractive at this price level for long-term income oriented investors.

To summarize, if you are interested in the dividend income from potentially undervalued large-cap stocks, you might want to take a look at Walgreen, Medtronic and Northrop Grumman.

Source: 3 Undervalued Dividend Large-Cap Stocks